Financial literacy is like asking a customer who is being wheeled into a surgery “Do you want 14 sutures or 17?” With this comment, we discovered common ground with Prof. Robert Merton, Nobel Prize winning Economist!

Nachiket and I had a long meeting with Prof. Merton to share our thoughts on the “wealth management” approach to providing financial services in remote rural India and seek his guidance. He was very appreciative and supportive of the approach we are taking towards the delivery of financial services and felt that this was the way that financial services needed to be delivered to all households.

Here is a quick summary of our discussion:

1) He felt that the general direction to go was “easier for the user and more complex for the financial services provider”. This is the exact inverse of what seems to be happening today.

2) He felt that in the wealth management process, we should have an ability to have the conversation with the customer about various trade-offs. For ex: if your lifecycle goal is to get your child an engineering education and the current levels of wealth and savings are simply not adequate – the WM (Wealth Manager) must lay out the trade-offs explicitly for the customer: are you willing to work and earn more? Save more? Forego some consumption now? Take more risk on portfolio allocation?

3) We have been struggling with estimating utility functions for our customers. He felt that rather than go in the direction of estimating household-by-household utility functions (which are hard to estimate, very unstable, coloured by recent “consumption memories”), the more productive and robust direction would be to use simpler approaches where the utility function provides a sanity check for the simulator:

With a moderate risk aversion and a simple utility function that is invariant to the level of wealth, calculate the utility over the actual consumption level less the minimum consumption level required for survival. That way, as the actual consumption level approaches the minimum consumption level the marginal utility of one unit of consumption rises sharply without having to explicitly incorporate a wealth effect in the utility function.

He also felt that if there were specific target expenditures that the household had this could receive similar treatment as well – particularly with respect to the lower bound on that expenditure. In our context the marriage of a daughter/education could present such an item of expenditure.

4) His own sense was that we needed to decentralise the data collection process but centralise the diagnosis and prescription process through strong back-ends and perhaps reduce the role of judgement to be employed by the Wealth Manager.

John Taylor spoke recently at RBI’s LK Jha lecture series. The lecture was a revisit to what Taylor has been saying all along – the crisis was caused by policymakers/policies/government and not firms/markets. He also reviews how emerging economies were better off in this crisis (see his blogposts as well – one and two).